The
cash-basis professional services taxpayer operated as
a calendar-year C corporation and was owned by three
major shareholders during 2001–2003. The shareholders
owned various related entities that did not perform
any services for the taxpayer in the years at issue.
The shareholders themselves performed various services
for the taxpayer, including accounting, consulting,
and management services. The taxpayer’s other
employees (approximately 40) performed accounting and
consulting services for the taxpayer. The shareholders
were paid various amounts throughout each year that
were designated as compensation. In addition, the
taxpayer made a number of payments to the related
entities that were designated as “consulting
fees.”

The taxpayer paid its available cash at
the end of each year to two of the related entities,
reducing its taxable income to zero (or near zero). A
compensation committee then allocated the related
entity payments among the shareholders according to
the hours each shareholder worked for the year. The
related entities, in turn, paid the shareholders
amounts that approximated the committee’s allocation.
The payments to each shareholder by the related
entities were thus proportionate to his hours worked
in relation to the other shareholders and not to his
ownership.

The taxpayer claimed deductions for
consulting fees for amounts it paid to the related
entities, which in turn paid the three major
shareholders totals of $911,570 for 2001; $866,143 for
2002; and $993,528 for 2003.

The IRS determined
tax deficiencies of $317,729 for 2001; $284,505 for
2002; and $377,247 for 2003, primarily from its
disallowance of the consulting fee deductions. The Tax
Court, applying the independent-investor test, upheld
the IRS’s determination.

On appeal, the Seventh
Circuit affirmed the Tax Court’s decision. In
explaining the independent-investor test, the court
noted that owner-employees have an incentive to
recharacterize dividends as salary, and courts from
time to time must decide whether income denominated
as salary is really a dividend and thus has been
improperly deducted from the corporation’s income.
In most cases, the taxpayer is a closely held
corporation in which most or all of the shareholders
draw salaries as employees.

The court
further explained that businesses organized in
corporate form combine labor and capital to produce
goods or services for sale. If the sales generate
revenues that exceed the costs of the company’s
inputs, a business has profits. Some of the labor
inputs into a business may come from an
owner-employee, who is compensated in the form of
salary. An owner-employee may also receive a share of
the profits in the form of dividends as compensation
for capital inputs. Whether the deduction claimed for
the owner-employee is a dividend can usually be
determined by comparing the corporation’s reported
income with that of similar corporations, in terms of
measuring return on equity. The higher the return, the
stronger the evidence that the owner-employee deserves
significant credit for his corporation’s increased
profitability and thus earns his high salary. The
presumption is that salary paid to an owner-employee
is reasonable and not a disguised dividend if the
business generates a higher percentage return on
equity than its peers.

The Seventh Circuit
stated:

The closer the owner-employee’s salary is to
salaries of comparable employees of other companies
who are not also owners of their company (or to
salaries of non-owner employees of his own firm who
make contributions comparable to his to the firm’s
success), the likelier it is that his salary was
compensation for personal services and not a
concealed dividend.

But what if, as in a
typical small professional services firm, the firm’s
only significant input is the services rendered by
its owner-employees? Maybe it has no other employees
except a secretary, and only trivial physical
assets—a rented office and some office furniture and
equipment. Such a firm isn’t meaningfully distinct
from its employee-owners; their income from their
rendition of personal services is almost identical
to the firm’s income. The firm is a pane of glass
between their billings, which are the firm’s
revenues, and their salaries, which are the firm’s
costs. To distinguish a return on capital from a
return on labor is pointless if the amount of
capital is negligible. . . .

The taxpayer in
this case is not the very small firm of our example;
it is not a “pane of glass.” It has physical capital
to support some 40 employees in multiple branches,
and it has intangible capital in the form of client
lists and brand equity—and capital in a solvent firm
generates earnings. [Mulcahy, Pauritsch,
Salvador & Co., slip op. at 4–5
(citations omitted)]

Given this
analogy, the Seventh Circuit held the Tax Court was
correct to reject the taxpayer’s argument that the
consulting fees were salary expenses. The salaries
reduced the taxpayer’s income and the potential return
to equity investors to zero or below in two of the
three tax years at issue. Because no investor would
find this level of return on equity acceptable, the
court found that the corporation had failed the
independent-investor test and that the IRS had
properly recharacterized the consulting fees as
dividends.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein
Reminick LLP, DFK International/USA, in New York
City.

For additional information about these
items, contact Mr. Wong at 212-697-6900, ext. 986 or
awong@hrrllp.com.

Unless otherwise noted, contributors are members
of or associated with DFK
International/USA.

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